Saturday, March 22, 2014

Why I Sold This Dividend Stock for a Loss

As the saying goes, the most valuable investing lessons are learned from observing other investors’ mistakes.

Or something like that.

Well, have an investing lesson on me, as I’ve made a pretty decent mistake in my portfolio.

Earlier this week, I made the very difficult decision to close my three year investment in UK-based grocer and retailer, Tesco plc (LON: TSCO) and realized a 22% loss on capital -- just the type of permanent loss that we're trying to avoid.

Granted, the generous income return from the Tesco investment lessened the sting of the capital loss, but the investment performed poorly on an absolute basis -- and even more so if we’re measuring it relative to the market.

These things happen, though. Let's at least learn something from it.

So, what went wrong?

Looking back, my original thesis was reasonable. Tesco had steadily increased its dividend each year for well over a decade, margins stayed in a tight range, the new management team seemed capable, etc.

The trouble started a year or so into the investment when I didn’t follow my own selling advice and held on while the thesis deteriorated.

Two prongs of my initial thesis on Tesco were that the company’s mis-timed expansion in the U.S. (Fresh & Easy) would eventually stabilize and rebound as the U.S. economy recovered -- particularly in the western states where the stores were located. Further, I thought Tesco’s investments in China would fuel earnings and dividend growth for years to come.

Neither of these things worked to plan. In April 2013, Tesco announced it was exiting the U.S. market and Fresh & Easy filed for bankruptcy protection. All of this resulted in a over a billion dollars in trading losses and impairments. That in itself should have been a sign to sell.

I rationalized, however, that with the Fresh & Easy chapter finally shut, Tesco could better focus on its other global operations. 

Strike one.

Tesco also never figured out how to turn a steady profit in China. Ultimately, Tesco entered into a joint venture with a large Chinese retailer who actually knew how to run a retail business in China. So much for the region fueling dividend growth. 

Strike two.

With Tesco’s focus on its struggling international operations, it began losing ground to competitors in its home market. Indeed, a space race/pricing war erupted between Tesco and other U.K. grocers like Sainsbury's and Morrisons. Meanwhile, discounters and higher-end grocers feasted on the opposite ends of the spectrum.

Even though Tesco seemed best suited to survive his war of attrition, profit margins have suffered. This put further strain on both free cash flow- and earnings-based dividend cover. In response, Tesco’s held its dividend flat for the last two years and recently abandoned its profit margin target.

Strike three.

As an aside, when I first invested in Tesco, two of my favorite investors (Neil Woodford and Warren Buffett) owned the stock. Buffett even increased his stake a few months after I invested, which I believed supported my thesis. Around the same time, however, Woodford was paring his investment in Tesco after owning the stock for well over a decade. (Buffett would later reduce his holding, as well). 

I might have paid too much attention to this factor. Certainly having top-notch investors on the same side of an investment can be reassuring. They've also done the research and think this particular stock is a good investment. Still, it's important to remember that their motivations for owning the stock could be very different from yours. 

Why not be patient?

The purpose of the Clear Eyes Investing blog is to promote long-term and patient investing. It’s important, however, not to confuse patience and hope.

In investing, patience is allowing the companies in your portfolio (that you bought at good-to-fair prices) to compound returns through their advantaged business models. Hope, on the other hand, is a wish or desire for something to occur when the fundamentals don't add up.

I fear I may have been “hoping” for a Tesco turnaround a bit too long.

There’s little point in hoping that a stock price will return to your cost basis if new information suggests otherwise. As such, it's important to revisit and refresh your assumptions every so often.

Using a back-of-the-envelope H-Model (H-Model explained here) and plugging in a range of what seem to be reasonable scenarios, I didn’t like what I saw:

*Just noticed the typo -- should be column and row, not column and column.
This is an admittedly simple valuation model, but it does suggest that even at 290p per share, Tesco may not be cheap right now. That's certainly the case if the company doesn't resume mid- to high-single digit annual dividend growth.

And a resumption of dividend growth seems unrealistic considering Tesco's current yield over 5% (~1.7 times the market average), lack of free cash flow cover, and no apparent end to the UK grocer pricing war. I don’t see any reason why Tesco will have the desire nor the financial ability to restart its dividend growth in the near future.

As a check on my dividend outlook, I plugged Tesco’s most recent financials into the Dividend Compass. I wasn’t impressed by the results as the score has declined to very low levels.

In recent years, Tesco's supported its dividend through real estate monetization (i.e. sale and leaseback arrangements, etc.) and not via free cash flow generated through operations. Put simply, that’s not a sustainable strategy. Tesco’s dialing back capital expenditures in the next few years to improve free cash flow, but it’ll also need to grow cash flow from operations if it’s going to consistently cover the payout with free cash flow.

Tesco’s closest peers like Sainsbury's and Morrisons are also trading with dividend yields over 5% and I have some concern that if one of them decides to cut their payout, the others will be more inclined to follow suit.

Tesco shares may in fact turn around and I might be wrong in selling here, but fresh analysis suggests it’s the right move. Time will tell, of course, and I'll look to reallocate my cash elsewhere.

Lessons learned

At the very least, I hope my financial loss provides some valuable lessons and that we can use them to improve our investment processes.

Here are five key lessons/reminders that I’m taking from this case:

  • When you find yourself making a lot of excuses for a company’s missteps, it’s time to reevaluate your investment thesis. Remember, you don’t work for the company and there’s no reason to spin bad results in a positive light. Call them as you see them.
  • If a company holds its dividend flat after years of steady growth, it’s likely a sign that the competitive landscape and/or company’s strategy has changed. The board and management are clearly not confident in their medium-term outlook. Something is up.
  • When figuring out when to buy or sell a stock, don’t concern yourself with which investors are also buying or selling the stock. Fund managers with large assets under management can have very different investment criteria and objectives than you and I do. They can also make mistakes like anyone else.
  • Forget the price you paid for the stock. The question you need to answer is, “Would you buy the stock today?” Anchoring is a powerful behavioral bias. To combat anchoring, write down your original thesis and periodically review it and update your assumptions. Has anything materially changed?
  • Even a solid research process can have a poor outcome. On average and over time, a good process should yield better results, but on a case-by-case basis this isn’t always true. Learn from the poor outcome and move onto the next investment.

Please post any questions or comments you have in the comments section below.

Good reads this week
Quote of the week
At Berkshire, we much prefer owning a non-controlling but substantial portion of a wonderful company to owning 100% of a so-so business; it’s better to have a partial interest in the Hope diamond than to own all of a rhinestone. -Buffett